Robert Way
In a market that is increasingly worried about what 2023 will hold for the global economy in general and short-cycle industrial markets in particular, Honeywell (NASDAQ:HON) stands out. There are a few parts of Honeywell’s business that likely won’t be at their best next year, but a solid two-thirds of the business should be seeing strong demand at a time when many other quality industries will be struggling with weaker conditions.
When I last wrote about Honeywell, I lamented the Street’s fickle treatment of the shares and thought it was a name to consider if the shares pulled back further. While the shares are now up about 5% from that time, investors did have two opportunities to pick up shares in the $170s (or about 15% below today’s price). Right now I see a bit of a split between the valuation and the secular appeal of the shares – I don’t see the stock as all that cheap (it seldom is), but I do think it is better placed than most, and could earn a sustained premium to its peers through 2024.
Mixed Trends, But Solid On A Core Basis
Honeywell’s third quarter results were flawless, but 9% organic growth and a 3% operating income beat is nothing to complain about, not to mention healthy trends in the company’s backlog.
Revenue rose 6% as reported, or 9% in organic terms (and 10% ex-Russia), missing expectations by a small margin. Gross margin improved by a point from last year (to 33.2%), while operating income rose 9%, with margin up 60bp to 21.8%. Segment-level profits rose 11%, with margin improving 110bp to 23.1%, with improvements in every segment.
Aerospace revenue rose 10%, beating by 2%, with Commercial Original Equipment up 30%, Commercial Aftermarket up 24%, and Defense down 10%. Segment profits rose 11%, beating by 5%, with margin up 40bp to 27.5%. While Honeywell’s defense performance has been leaving something to be desired relative to peers like Lockheed Martin (LMT) and General Dynamics (GD), the commercial aero business has been strong, due in part to elevated exposure to the very strong bizjet market, though not as strong as General Electric (GE).
Home & Building Technologies revenue rose 19%, missing by 1%, with 23% growth in products and 13% growth in solutions. Segment profits rose 14%, missing by 1%, with margin up 60bp to 24.1%. I haven’t seen enough good comps yet to properly benchmark Honeywell to peers/rivals, but it does sound as though energy efficiency retrofits are still providing a tailwind.
Safety & Productivity Solutions posted a 4% revenue contraction, missing by 5%, with a significant (15%) decline in the Warehouse/Workflow group and modest growth elsewhere. Profits missed by 1%, with margin up 250bp to 15.7%. The business continues to be hurt on the topline by weaker demand from e-commerce customers like Amazon (AMZN) as well as management’s own desire to slow growth and focus more on margins; given the weaker margins of Intelligrated and other related businesses, slower growth here boosts margins. KION (OTCPK:KIGRY), among others, has echoed this trend of sharply lower new investments in warehouse automation projects.
Performance Materials and Technologies revenue rose 14%, beating by 6%, with 6% growth in UOP and process and 33% growth in Advanced Materials. Honeywell saw healthy demand for refining catalysts and gas processing and control systems for process industries like biopharma and petrochemicals, while Solstice and other specialty products are growing nicely.
Honeywell’s backlog grew 9% yoy but did shrink slightly (1%) on a sequential basis. I would also note that volume was negative in the quarter, as pricing contributed 11% to growth.
Better-Placed Than Most For 2023
Many high-quality industrials have sold off on weakening business confidence and expectations of a slower macroeconomic environment hitting short-cycle markets in 2023, as the PMI looks about to head below 50 for a time.
Honeywell stands out, though, for a business mix that is likely to be quite strong next year. Aerospace was about one-third of this quarter’s revenue (and close to 40% of segment profits), and commercial aerospace should continue to recover; a weak macro could slow the air travel recovery, but aircraft demand is still improving and Boeing (BA) should be increasing their production (that company will be hosting an investor day next week, where that’s sure to be a topic of conversation). I could see bizjets slowing some, but I also think defense should rebound.
The PMT segment should also be strong. This business contributed about 30% of Q3 revenue and 30% of Q3 segment profits, and I expect strong demand related to LNG (replacing Russian gas supplies), as well as strong fluorine product demand, ongoing longer-cycle process industry project demand (including biopharma/life sci), and clean energy. I could see some weakness on the electronics side (part of Advanced Materials), but I don’t think it will be a major headwind.
Within SPS, I expected 2023 will be another year of “absorption” for warehouse automation customers, so I don’t expect strong results from Intelligrated. Core safety should be better, though, after annualizing pandemic-related demand and gas detection should remain healthy.
HBT is a harder business to assess. I like Honeywell’s pivot toward more control products and its position as an enabler of automation and electrification. I also like the building retrofit opportunities created by the Inflation Reduction Act, but I do believe that most non-residential building categories will be weaker, and those trends may cancel each other out.
The Outlook
There’s a lot going on right now at Honeywell. In addition to the commercial aerospace recovery and the opportunity to leverage strong LNG-related demand next year (and new clean energy technologies in the future), I do still see strong long-term opportunities in electrification and automation. On top of that, there’s Honeywell’s stake in Quantinuum (quantum computing), ongoing development of opportunities in urban air mobility and unmanned vehicles, and an overall larger commitment to more R&D investment into new technologies.
I also think Honeywell could get more active in M&A. I don’t see the company looking to get into aircraft engines, but I could see them looking to make add-on deals in aerospace and possibly in areas like biopharma, controls/automation, clean energy/energy technology, and business software.
I’m still looking for around 5% long-term revenue growth from Honeywell, with FCF margin improvement toward 20% driving around 8% long-term FCF growth. Longer term, I see upside to margins in the SPS business as it matures and gains scale, and I think a greater focus on controls and software in HBT can drive higher margins there over time.
The Bottom Line
Between discounted cash flow and margin/return-driven EV/EBITDA, I think Honeywell is basically fairly valued today. There are far worse things, though, than owning a great company at a fair price. I also believe that Honeywell could do well in 2023 from a sentiment standpoint, as its business will likely hold up better if there is that expected short-cycle slowdown.
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